Rules for CDS Used to Lower Capital Requirements Could Be Revised

Global regulators are planning to lay down stricter rules for banks that are window dressing their capital requirements by using credit-default swaps and other instruments in devious ways to lower the amount of risk on their balance sheet.

The Basel Committee on Banking Supervision said that it will deter banks lowering capital charges by acquiring instruments including CDS to protect against losses, and at the same time running away from accepting the large liabilities they incur from what they pay for this protection.

The Basel Group, which consists of regulators from 27 nations including the U.S., U.K. and China, told that it, would hear out the views on the amendments to the capital rules that will mandate the banks to account for the cost of the protection they receive, till June 21st.

Switzerland-based group told that the proposed changes will ensure that not only the benefits of the purchased credit protection are accounted but also the associated costs are included in the regulatory capital. The Basel group added there exists a “potential for capital arbitrage” as the banks can account for the benefits of these without also booking the related costs.

The rules from the Group are an answer to “continued activity in high cost credit protection transfers,” the committee said.

The regulations planned by the group are expected to boost bolster banks’ solvency after the financial crisis. Talking of banks, credit-protection transactions allows the flexibility to use capital in a more efficient way and at the same meeting the tough requirements laid by the latest round of Basel rules. Experts are of the opinion that such transactions apart from protecting the lenders push the lending risk into the unregulated shadow-banking industry.

“Regulatory capital arbitrage may exist where the immediate capital relief” provided by credit protection “will be offset by the premiums paid” over the life of the contract, the group said.

The world’s largest private-equity firm, The Blackstone Group L.P. (NYSE:BX), insured Citigroup Inc. (NYSE:C) against any initial losses on a $1.2 billion pool of shipping loans, last year. As per the person’s familiar with the transactions, regulatory capital trade, Blackstone’s first, let Citigroup cut how much it sets aside to cover defaults by as much as 96 percent while keeping the loans on its balance sheet.